Class Notes (906,006)
CA (538,586)
UTSC (32,642)
MGEA06H3 (176)
Iris Au (165)
Lecture

Lecture notes for week 9

5 Pages
147 Views

Department
Economics for Management Studies
Course Code
MGEA06H3
Professor
Iris Au

This preview shows pages 1-2. Sign up to view the full 5 pages of the document.
BANKING SYSTEM AND MONETARY POLICY
Outline
x Discuss the two types of banks—commercial bank & central bank.
x The balance sheet of a commercial bank.
x The role of the banking system—how it generates money.
x What is the monetary system?
x Measures used by the central bank to affect money supply.
x The link between monetary policy and the real side of the economya revisit.
Types of Banks
There are two types of banks: commercial banks and central bank.
Commercial Banks
x Commercial banks are privately owned, profit-seeking institutions that provide a variety of financial services such as accepting
deposits from customers and making loans and other investments.
x In Canada, the banking industry is dominated by chartered banks.
x Chartered banks in Canada include RBC, BMO, CIBC, TD-Canada Trust, and Scotiabank.
x Chartered banks are subject to federal regulations and only until recently were required to hold reserves with the Bank of Canada
(BOC) against their deposit liabilities.
x The required reserve requirement was eliminated in 1994 but chartered banks still hold “voluntary reserves with the BOC.
Central bank—the Bank of Canada (BOC)
x The BOC was established in 1935 and became a crown corporation in 1938.
x In practice, the operation of the BOC is independent of the Federal government (i.e., the government could not intervene into the
operation of the Bank of Canada).
x The BOC performs the following functions:
1) Print money & “in charge” of money supply
2) Lender of last resort: The BOC acts as bankers’ bank.
o If commercial banks need to borrow money to stay afloat or remain liquid, they can borrow from the BOC.
o However, there is no free lunch. When commercial banks borrow from the BOC, the BOC will charge them interest.
The interest rate that the BOC charged is called the bank rate.
3) Banker to Canadian government: BOC manages government bank accounts, foreign exchange reserves, and national debt.
The Balance Sheet of a Bank
x The balance sheet of a (commercial) bank:
Assets Liabilities
Cash & reserves
Loans
Demand deposits
Equity
Note:
x Cash & reserves—cash held by the commercial bank. Commercial bank keeps sufficient cash on hand to be able to meet the
depositor’s day-to-day requirements for cash.
x Equity—the difference between bank’s assets and bank’s liabilities.
The Reserve Ratio
x The reserve ratio (rr) refers to the fraction of its deposits that a commercial bank holds as cash & reserves.
o The reserve ratio is fraction Æ 1 > rr > 0.
x Before 1994, commercial banks were required to hold required reserves.
o The law required commercial banks to hold a minimum amount of cash as reserves for every dollar they accepted as deposits.
x Now, there is no required reserve requirement but banks do hold “voluntary or target reserves. Why?
o To ensure that they have cash to satisfy daily withdrawals of the depositors Æ to avoid bank run.
x We should interpret the reserve ratio as the “target reserve ratio”—the fraction of deposits that commercial banks would like to
hold in the form of cash and reserves.
Commercial Banks and Money Creation
x This section examines how commercial banks help to create money.
The Set Up
x Initially there are no banks and total quantity of currency circulated is $200, all held by the public (currency in circulation = $200).
MS = currency in circulation + demand deposit
MS = $200 + $0 = $200
x Now, someone dreams up the idea of a “chartered bank” and opens one with $40 of cash invested in the bank (bank’s equity = $40).
o People can deposit their money in the bank.
o Once they open bank account and deposit money in their accounts, they can write cheques.
x Now, suppose that people deposit another $60 of their cash in the bank.
o The new bank has $100 in cash ($40 in equity, $60 in demand deposits).
www.notesolution.com
x Assumption: People are happy with $100 in cash in their pockets, and they would deposit anything else into the bank (i.e., if they
have more than $100 in their pockets, they would deposit the “extra” cash in their bank accounts).
The chartered bank’s balance sheet—Beginning
Assets Liabilities
Cash & reserves $100
Loans $0
Demand deposits $60
Equity $40
x Question: What is the level of MS (say M1) after the bank is established?
x Answer: M1 = currency in circulation + demand deposit
M1 = MS = $100 + $60 = $160 (MS decreases by $40)
How the Chartered Bank Creates Money?
x Now, let’s see how this newly found chartered bank helps to create money by making loans.
x Assumption: The target reserve ratio is 10% (rr = 0.1).
x Question: If the (target) reserve ratio is 10%, would the chartered bank be happy with its current position?
x Answer: No, the chartered bank is way out of equilibrium and is losing money.
o The bank is not generating any revenue (if the bank is not making any loan, how does the bank earn income?).
o However, the deposits will need to be paid back eventually (plus the interest paid to deposits).
o In this case, the bank holds excess reserves.
Actual reserve ratio = $100 / $60 = 1.67
Target reserve ratio = 0.1
: the bank holds excess reserves (actual reserve ratio > target reserve ratio)
x Question: What should the chartered bank do?
x Answer: try to decrease the reserve ratio to its target ratio (10%) by making loans
Indeed, the bank will keep making loans until the reserve ratio = 10%.
x Question: How does the bank lend money?
x Answer: By creating demand deposit.
o In real life, the bank does not really give you cash when it makes loans to you. The bank just creates a demand deposit with
your name on it so that you can draw on.
o When you spend that money (say writing cheques), then the money just goes from your account to someone else’s account.
The Chartered Bank Begins to Make Loans
Suppose the bank lends out $90.
x Question: What happens to the bank’s balance sheet?
The bank’s balance sheet—Immediately after $90 in loan
Assets Liabilities
Cash & reserves $100
Loans $0 + $90
Demand deposits $60 + $90
Equity $40
x Note: The bank still holds excess reserves.
Target reserve ratio = 0.1
Actual reserve ratio = $100 / $150 = 2/3 = 0.67
: this is still higher than the target reserve ratio
: continue to make more loans
x The key is that the new demand deposits never actually leave the system!
The Chartered Bank Continues to Make Loans
What happens if the bank continues to make loans so that the reserve ratio is eventually equal to the target ratio of 10%?
x The maximum amount of demand deposits that would be supported by the initial $100 reserves is:
0.1 = $100 / DD
Æ
DD = $1000 (this is the maximum amount of demand deposits that the bank can make)
x Question: What would the final balance sheet of the chartered bank look like?
The bank’s balance sheet—when reserve ratio reaches it target ratio.
Assets Liabilities
Cash & reserves $100
Loans $940
Demand deposits $1000 = $60 + $940
Equity $40
x It seems that the banking system has seeminglycreated” $940 loans in new money. Why?
MS = currency in circulation + demand deposits
Final” MS = $100 (cash held by the public) + $1000 (total DD in bank) = $1100
ûMS = “Final” MS – Initial MS (when the bank is found) = $1100 – $160 = $940 (ûMS = amount of loans created by bank)
x Question: How could the chartered bank create money? Is this a trick?
x Answer: No, there is no trick. The banking system DOES CREATE money! We call this money creation.
o As the bank loans out money, this money gets deposited back into the banking system, which is then available for the bank to
loan out again. Then, more loans are being created and get re-deposited back into the banking system Æ MS increases.
o In our example, the process continues until the reserves reach its target ratio; i.e., the bank will keep making loans until its
reserves are 10% of the demand deposits.
www.notesolution.com

Loved by over 2.2 million students

Over 90% improved by at least one letter grade.

Leah — University of Toronto

OneClass has been such a huge help in my studies at UofT especially since I am a transfer student. OneClass is the study buddy I never had before and definitely gives me the extra push to get from a B to an A!

Leah — University of Toronto
Saarim — University of Michigan

Balancing social life With academics can be difficult, that is why I'm so glad that OneClass is out there where I can find the top notes for all of my classes. Now I can be the all-star student I want to be.

Saarim — University of Michigan
Jenna — University of Wisconsin

As a college student living on a college budget, I love how easy it is to earn gift cards just by submitting my notes.

Jenna — University of Wisconsin
Anne — University of California

OneClass has allowed me to catch up with my most difficult course! #lifesaver

Anne — University of California
Description
BANKING SYSTEM AND MONETARY POLICY Outline N Discuss the two types of bankscommercial bank & central bank. N The balance sheet of a commercial bank. N The role of the banking systemhow it generates money. N What is the monetary system? N Measures used by the central bank to affect money supply. N The link between monetary policy and the real side of the economya revisit. Types of Banks There are two types of banks: commercial banks and central bank. Commercial Banks N Commercial banks are privately owned, profit-seeking institutions that provide a variety of financial services such as accepting deposits from customers and making loans and other investments. N In Canada, the banking industry is dominated by chartered banks. N Chartered banks in Canada include RBC, BMO, CIBC, TD-Canada Trust, and Scotiabank. N Chartered banks are subject to federal regulations and only until recently were required to hold reserves with the Bank of Canada (BOC) against their deposit liabilities. N The required reserve requirement was eliminated in 1994 but chartered banks still hold voluntary reserves with the BOC. Central bankthe Bank of Canada (BOC) N The BOC was established in 1935 and became a crown corporation in 1938. N In practice, the operation of the BOC is independent of the Federal government (i.e., the government could not intervene into the operation of the Bank of Canada). N The BOC performs the following functions: 1) Print money & in charge of money supply 2) Lender of last resort: The BOC acts as bankers bank. o If commercial banks need to borrow money to stay afloat or remain liquid, they can borrow from the BOC. o However, there is no free lunch. When commercial banks borrow from the BOC, the BOC will charge them interest. The interest rate that the BOC charged is called the bank rate. 3) Banker to Canadian government: BOC manages government bank accounts, foreign exchange reserves, and national debt. The Balance Sheet of a Bank N The balance sheet of a (commercial) bank: Assets Liabilities Cash & reserves Demand deposits Loans Equity Note: N Cash & reservescash held by the commercial bank. Commercial bank keeps sufficient cash on hand to be able to meet the depositors day-to-day requirements for cash. N Equitythe difference between banks assets and banks liabilities. The Reserve Ratio N The reserve ratio (rr) refers to the fraction of its deposits that a commercial bank holds as cash & reserves. o The reserve ratio is fraction 1 > rr > 0. N Before 1994, commercial banks were required to hold required reserves. o The law required commercial banks to hold a minimum amount of cash as reserves for every dollar they accepted as deposits. N Now, there is no required reserve requirement but banks do hold voluntary or target reserves. Why? o To ensure that they have cash to satisfy daily withdrawals of the depositors to avoid bank run. N We should interpret the reserve ratio as the target reserve ratiothe fraction of deposits that commercial banks would like to hold in the form of cash and reserves. Commercial Banks and Money Creation N This section examines how commercial banks help to create money. The Set Up N Initially there are no banks and total quantity of currency circulated is $200, all held by the public (currency in circulation = $200). MS = currency in circulation + demand deposit MS = $200 + $0 = $200 N Now, someone dreams up the idea of a chartered bank and opens one with $40 of cash invested in the bank (banks equity = $40). o People can deposit their money in the bank. o Once they open bank account and deposit money in their accounts, they can write cheques. N Now, suppose that people deposit another $60 of their cash in the bank. o The new bank has $100 in cash ($40 in equity, $60 in demand deposits). www.notesolution.com
More Less
Unlock Document


Only pages 1-2 are available for preview. Some parts have been intentionally blurred.

Unlock Document
You're Reading a Preview

Unlock to view full version

Unlock Document

Log In


OR

Don't have an account?

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


OR

By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.


Submit